ENERGY ECONOMICS Stef Proost & Guido Pepermans Acco Leuven / Den Haag
CHARTER 0 Economics Refresher 17 1 Introduction 17 2 The market 18 21 Individual demand 18 2 2 Aggregate demand 19 2 3 Optimal allocation of demand 20 2 4 Individual supply function 20 2 5 Aggregate supply 21 2 6 Optimal allocation of supply 21 2 7 Competitive market equilibrium 22 3 Market power 24 31 Monopoly 24 3 2 Imperfect competition 25 4 Who bears the costs of taxation? 28 5 Public goods 29 6 External effects 30 7 Conclusion 31 8. Exercises 31 9 References 32 CHARTER 1 History and future of energy use 33 1 Introduction 33 2 Drivers of energy use and energy prices 33 21 Energy use in the production sector 33 2 2 Energy use by final consumers 37 2 3 Main drivers of energy use 40 3 Energy in historical perspective 41 3 1 Income and population growth 41 5
3 2 Energy use for household heating 43 3.3 Energy use for power 44 3.4 Price of lighting services 45 3 5 What happened to energy prices and the price of energy services over the last 700 years? 46 3.6 Energy consumption 46 4. Future trends 47 5 Understanding world energy markets 49 51 Aggregate energy demand by type of energy 50 5.2 Aggregate energy supply by type of energy 51 5.3 Equilibrium on the energy markets 52 5 4 Why is making scenarios for the future difficult? 52 6. Conclusion 53 7. Exercises 53 a. References 53 CHARTER 2 Economics of non-renewable resources 55 1. Introduction 55 2 Classifying resources 56 3 Optimal allocation of a non-renewable resource over Urne - the N period case 57 31 Basic N-period model 58 3 2 Basic N-period model with backstop 60 3.3 Increasing marginal cost of extraction 61 3.4 Reserve dependent costs 62 3 5 Comparative statics of the continuous extraction problem 62 3 6 Higher discount rate 65 3 7 An increase in the size of the resource stock 65 3.8 Effect of a higher marginal extraction cost 66 3 9 Increase in the expected demand 66 310 A fall in the cost of the backstop technology 67 311 Interpretation of the comparative statics exercise 68 4. The allocation of non renewable resources in a market economy 69 41 Perfect competition case 69 4.2 Monopoly case 70 4.3 Some more issues that arise in a market context 72 4 31 Royalty and revenue tax 72 4.3.2 Forward markets and expectations 72 4.3.3 Some normative issues 72 B
5 How does the model perform in reality? 73 6 Conclusion 74 7 Exercises 74 а. References 75 CHARTER 3 Environment 77 1 Introduction 77 2 Basic environmental economics 77 21 Problem setting 77 2 2 Ideal (or theoretically optimal) Solution 80 2 3 Non-cooperative Solution 84 2 4 Centralized government Solution 85 2 4 1 A tax on emissions 86 2 4.2 An emission Standard 87 243 A tradable emission scheme 87 2 4 4 Overview of properties of the different Instruments 88 3 The effect of different environmental policy Instruments on market prices and profits 89 31 An analytical Illustration for the car market 90 3 2 Effects of different Instruments on profits 94 4 Conclusion 96 5 Exercises 96 6 References 97 CHARTER 4 The energy saving gap 99 1 Introduction 99 2 An Investment model 100 3 Empirical evidence on the Investment inefficiency 102 3.1 Engineering estimates of energy saving cost curves 103 3.2 Empirical estimates of returns on Investment 103 3.3 Cost-effectiveness of energy conservation programs 104 3.4 Trade-offs between durable goods 104 3.5 Possible explanations of the energy efficiency gap 105 4 Policy implications 105 5 Conclusion 106 б. Exercises 106 7 References 106 7
CHARTER 5 Sustainability 109 1. Introduction 109 2 Sustainability as a maximum of discounted Utility 109 3. Sustainability as guarantee for Utility of future generations 112 4. Conclusion 114 5. References 115 CHARTER 6 Economics of Climate Change 117 1. Introduction 117 2. Climate change is a worldwide issue 117 2.1 Emissions and climate 118 2.2 The origin of GHG emissions 122 2 3 The stock dimension of GHG emissions 123 3. How to select a climate change strategy in an ideal world? 124 3.1 A broader perspective 124 3.2 What objective function to select an optimal level of reduction? 125 3.3 Integrated assessment models to compute an optimal policy 127 3.4 Damage of climate change 129 3.5 Costs of emission abatement 130 3.6 What strategy for emission reduction? 133 4 Economics of international climate agreements 133 4.1 The one shot game 134 4.2 The repeated game 137 4.3 A catastrophic climate game 137 s, Conclusion 138 6. Exercises 138 7. References 139 CHARTER 7 European climate change policy 141 1. Introduction 141 2. EU Climate change policy 141 2.1 International negotiation strategy of the EU 141 2.2 European climate policy 143 B
2.2.1 Why a policy at EU level? 143 2.2.2 The choice of Instruments differs by sector 143 3. A closer look at the experience with the ETS in the EU 144 3 1 The Organization of the ETS system 144 3.2 Price formation of C0 2 permits 145 3.2.1 Impact of ETS on industry profits 148 4 A critical assessment of the European climate policy 150 4.1 The extent of the European effort 150 4.2 The effects on the international energy markets: can a unilateral effort be effective? 151 4 3 Choice of policy Instruments 153 5. Which way forward? 153 51 Credibility issues 154 5.2 A worldwide perspective on cost efficiency 154 5 3 Technology policies 155 5.4 Distinguishing between high rent and low rent fossil fuels 160 6. Conclusion 160 7 Exercises 160 8 References 161 CHARTER 8 Goal 163 1 Introduction 163 2. Some Conventions and definitions 163 21 Different types of coal 163 2.2 Units 164 2.3 Sources of data and forecasts 164 3 Main uses, consumers, producers and trade flows 164 3 1 Main uses 164 3 2 Main producers and consumers 166 3.3 Trade flows 166 4. How much coal is there? 167 4.1 Proven reserves 167 4.2 Resources 168 5 Economics of the coal market 169 5.1 Opening the coal sector to foreign trade 169 5.2 Theory of comparative advantage 170 5.3 Opening a sector to trade 171 5.4 Coal has high transport costs 173 9
6 Coal market Operations 7. Modelling the world coal market 7.1 Perfect competition model 7.2 Non-competitive models 8 History of the coal market in Western Europe 8.1 Second World War - 1970 8.2 From 1974-2004 8.3 From 2004 onwards 9 Conclusion 10. Exercises 11. References 173 175 175 176 176 176 177 178 179 179 180 CHARTER 9 Oil 181 1 Introduction 2. Some Conventions and definitions 2.1 The different types of oil 2.1.1 Units 2.1.2 Sources of data and forecasts 3 Main uses, consumers, producers and trade flows 3.1 Main uses 3.1.1 A digression on the use of oil for transportation 3.2 Consumption and main producers 3.3 Trade flows 4 How much oil is there? 4.1 Proved reserves 4.2 Resources 5 Three simple models for the world oil market 51 A simple oil market model with short and long run equilibria 5.1.1 Calibration of the model 5.1.2 Using the simple demand and supply model 5.2 A very short-term model of the oil market with speculators and oil stocks 5.3 An imperfect competition model for the oil market 6. Understanding the history of the world oil market 6 1 Before 1970 6.2 After 1970 6.2.1 1973 6.2.2 1979-1980 6.2.3 1980-1985 181 181 181 182 183 183 183 184 189 190 190 190 191 193 194 195 196 197 201 206 206 208 210 211 211 1 0
624 1986-2004 212 6.2.5 2004-2014 212 6 3 And the future? 212 7 Policies to stabilise or decrease oil prices 213 7.1 Emergency and Strategie stockpiles 213 7.2 Import taxes 213 7.3 Decreasing the oil dependency of the economy 214 7 4 Climate change policy and the world oil market 214 8 Price formation of Oil produets 214 9. Conclusion 216 10 Exercises 217 11. References 219 CHARTER 10 Gas 221 1 Introduction 221 2 Some Conventions and definitions 221 2.1 Different types of gas 221 22 Units 222 2.3 Sources of data and forecasts 222 3 Main uses, consumers, producers and trade flows 222 3.1 Main uses 222 3.2 Main producers 223 3.3 Trade flows 224 4 How much gas is there? 226 4.1 Proved reserves 226 42 Resources 228 5 Economics of the gas market 229 5.1 High transport costs 229 5.2 The hold-up problem for specific transport infrastrueture 230 5.3 Price discrimination 231 5.4 Netback pricing of natural gas and take or pay contracts 231 5 5 A Cournot equilibrium 232 6 History of the gas market in Western Europe 233 6.1 Before 1973 233 62 From 1974-2004 234 6 3 Since 2004 236 7. Modelling the European gas market 237 7.1 Structure of the model 237 11
7.2 Downstream: behavior of traders 238 7.3 Upstream: behavior of producers 240 7.4 Empirical specification 242 7.4.1 Calibration 242 7.4.2 Scenarios and results 243 8. The security of European gas supply 246 8.1 Introduction 246 8.2 Transporting Russian gas to Europe 246 8.3 How to deal with unreliable Russian gas supply? 248 8.3.1 Introduction 248 8.3.2 The model 248 8.3.3 The results 254 8.4 Will the development of shale gas contribute to the security of gas supply in Europe? 256 9. Conclusion 257 10. Exercises 258 11. References 259 CHARTER 11 Renewables 261 1. Introduction 261 2 Main uses, consumers and producers 262 3. Model of an electricity sector with C0 2 reducing policies 263 31 Theoretical model 264 3.11 Fossil fuel producers 265 3.1.2 Renewable producers 266 3.1.3 Consumers 268 3.1.4 Competitive equilibrium without policies 268 3.1.5 Economic surplus 269 3.2 Policies considered 269 3.2.1 Fixed price policies 269 3.2 2 Rate or Standard based policies 272 3.2.3 Summary comparison of policies 273 3.3 Optimal policy 274 3.4 Calibration of the model for the US electricity sector 275 3.4.1 Sensitivity analysis 278 3.5 Evaluation of the model 279 4. European union renewables policy 280 4.1 European renewable energy directive 280 1 2
4.2 Choice of policy Instruments 281 43 Case study: How cost-effective is green power support in Germany? 282 4.4 Technological change 283 4.5 Why focus on a specific target for renewable energy? 284 4 6 Which way forward for the EU? 286 5. World perspective on renewable energy 287 B. Conclusion 288 7. Exercises 289 8. References 291 CHARTER 12 Basic Electricity Economics 293 1 Introduction 293 2 Some Conventions and definitions 294 3 Main uses, consumers, producers and trade flows 294 3.1 Main uses 294 3.2 Electricity consumption 294 3.3 Electricity generation by fuel 295 3.4 Trade flows 296 4. Generation 296 4.1 The cost of power plants 296 4.2 Optimal Investment in generation technologies 298 4.2.1 Peak and baseload technologies 298 4.2.2 Screening curve method 299 4 3 Optimal pricing and Investment in generation capacity 302 4.3.1 One generation technology 302 4.3.2 Two generation technologies 305 4.4 Average-cost pricing vs. real-time pricing 310 4.5 Summary 313 5 Transmission 313 5.1 Graphical analysis 313 5.2 Numerical Illustration 315 6 Generation and transmission 318 6.1 Optimal locations for generation and consumption 318 6.2 Numerical Illustration 320 7 Conclusion 322 8 Exercises 323 9. References 324 13
CHARTER 13 Liberalization and Competition on the Electricity Market 325 1. Introduction 325 2 Why Liberalise Electricity Markets? 325 3 EU directives on energy liberalization 326 4. Emerging markets, structures and contract types 329 4 1 The real-time market 330 4 2 The short-run energy market 331 4.3 Financial Instruments 334 4.3.1 The effect of uncertainty for the market participants 334 4.3.2 Forward contracts 335 4.3.3 Futures contracts 337 5 Issues with liberalising electricity markets 340 51 Market power in the generation market 340 5.1.1 Detecting the presence of market power 341 5.1.2 Market power mitigation techniques 342 5 2 Regulating transmission and distribution 344 5 3 The adequacy problem 345 6 The British experience as case study 351 6.1 The Electricity Act 1989 351 6.1.1 Characterizing the market equilibrium 355 6.1.2 Performance after privatization 357 6.2 The New Electricity Trading Arrangements (NETA) 357 6.3 The Electricity Market Reform 360 6 4 Lessons from the British experience and differences with continental EU 361 7. Conclusion 362 8 Exercises 363 9. References 363 ACKNOWLEDGEMENTS 365 NOTES 367 14